NetEase: The Last Kneel Before the 'Pig Cycle'?

$NTES-S(09999.HK) $NetEase(NTES.US) released its Q3 2025 financial report for the Hong Kong stock market after the close on November 20, Beijing time. Similar to Q2, it was another miss under high expectations. Considering that some institutions mentioned the risk of overly high expectations at the beginning of the month, some funds may have been prepared.

In the current emotional environment, the market is certainly not satisfied with this performance. However, considering that the stock price has been adjusted for a long time, the punishment for the earnings miss may be mitigated due to the resilience of games and the expectation of improvement in the pipeline next year.

The most important focus now is the launch plans and revenue targets for two major games next year, "Sea of Oblivion" and "Infinity," and it is recommended to pay attention to related content in the conference call.

Specifically:

1. Games below expectations: In the third quarter, games did not accelerate compared to Q2 as the market expected, with the main expectation gap in PC games. Although in terms of absolute growth rate, PC games performed significantly better than mobile games.

During the summer of the third quarter, mobile games such as "Egg Party" and "Yan Yun Sixteen Sounds" underwent significant content updates, "Fantasy Westward Journey Mobile" launched a light version at the end of August, and the medium-sized "Spirit Pet Adventure" added volume, driving domestic mobile game revenue back to positive growth. Overseas, due to the release of the new game "Destiny: Stars," iOS revenue growth was 18%, which is also not bad.

Therefore, recalculating, Dolphin Research speculates that the market's expectations for PC game revenue were too high, possibly due to the outstanding performance of the "Fantasy Westward Journey" play version raising expectations. There is no reliable third-party data source to track PC games, so it is understandable that institutions have a large expectation gap.

Although there was an increase in Blizzard series games in the third quarter, competition in PC games also rose, especially with Tencent's PC games like "Delta Force," which may have had a diversion effect.

2. Deferred revenue is the only highlight: It is worth mentioning that Q3 deferred revenue significantly exceeded market expectations, growing by 25% year-on-year, better than the seasonal changes in Q2 and Q3 of previous years, similar to the third quarter when Blizzard just returned last year.

Roughly calculated, the revenue growth rate was 14%, achieving this growth rate in a high base + no major new mobile games in the current period reflects the resilience of evergreen games.

Generally speaking, overseas games and PC games have a slightly longer deferral cycle than domestic mobile games. The increase in the third quarter mainly came from overseas mobile games and domestic PC game revenue. Therefore, the slowdown in game revenue confirmed this quarter may also be related to changes in the deferral confirmation cycle.

3. Marketing expenses increased again: On the cost and expense side in the third quarter, the main expectation gap came from sales expenses, which were nearly 500 million more than expected. Although there were no major new mobile games this summer, NetEase put a lot of effort into refurbishing old games.

At the same time, to maintain and enhance player stickiness, offline activities and collaborations for evergreen games increased, and the overseas promotion of "Destiny: Stars" itself also incurred higher costs.

However, the market's expectations for current sales expenses were more linear, fitting the growth rate of the second quarter, possibly still influenced by NetEase's strict marketing strategy and anti-corruption efforts in the promotion team last year, leading to conservative expectations.

Ultimately, Non-GAAP net profit was 9.5 billion, with a profit margin of 34%. Since only SBC expenses were adjusted, although the absolute amount met expectations, it was mainly due to investment income (8 billion more year-on-year) and other items. Dolphin Research is more concerned about the core business operating profit, which was only 8 billion, 1 billion lower than market expectations.

4. Subsidiary business focuses on profitability: In businesses outside of games, Youdao Education and Cloud Music slightly underperformed BBG expectations, but the biggest drag was the Yanxuan business.

5. Shareholder returns are insufficient to support: In the third quarter, NetEase planned to distribute about 2.5 billion in dividends, with a payout ratio of 27%, which is relatively stable. Not only did the company not repurchase much in the third quarter, but it also extended the 5 billion USD repurchase plan that started in 2023 for another three years, effectively extending the expiration date to January 2029.

This greatly discounts shareholder returns. Currently, there is still 3 billion USD left in the repurchase quota. If repurchased over the next four years, it would average only 750 million USD per year, accounting for less than 1% of the current 84.5 billion market value. Even with a dividend yield of 2.2%, the total shareholder return is only 3%, providing limited support for the current stock price.

6. Overview of key financial indicators

Dolphin Research's View

Since the company rarely provides quantitative forward guidance, it is difficult for the market to grasp expectations for a game company whose revenue cannot be fully tracked. The third-quarter performance is certainly not satisfactory, so after the short-term market digests the expectation gap, Dolphin Research is more inclined to step out of expectations and discuss the marginal changes in NetEase's fundamentals and theoretically matched value from an objective and neutral perspective.

Although games achieved double-digit growth in the second and third quarters, it cannot cover up the current vacuum in the mobile game pipeline and the tense situation of peers' bumper harvests. Therefore, when Sensor Tower data shows that NetEase's mobile games only slightly declined in the second quarter and returned to slight positive growth in the third quarter, it reflects the ability to re-explore the value of old games. If viewed from the perspective of the end of last year and the beginning of this year, it is actually a pleasant surprise.

This elasticity exists in a leading game company like NetEase, with moderate self-regulation space, and of course, the strength of external competition will directly affect the adjustable space.

In recent years, the policy side has become increasingly positive, and although the issuance of game licenses cannot compare to the peak period, the trend of slow expansion in total volume has not changed. At the same time, in terms of the distribution of license issuance, efforts are made to maintain equal shares between large and small companies.

Therefore, there is no doubt that industry competition is intensifying, but for leading companies like Tencent and NetEase, the advantage of product quality will still ensure a baseline level of product performance, and if operated well, new evergreen trees can still be developed.

Perhaps due to the "equal distribution" of limited licenses, or perhaps to increase the hit rate and enhance the overall product ROI, both Tencent and NetEase's strategies are to reduce the number of products and improve product quality. This strategic change requires more internal adjustments for NetEase's previous product matrix strategic advantage. In addition, compared to new games, refurbishing old games can provide a more reliable bottom line.

It is precisely because the value of refurbishing old games continues to emerge that it has been recognized by the market: NetEase's market value has risen from 13x PE at the beginning of the year to 16x, and even reached 18-19x in the third quarter. Of course, at this time, there is also a more optimistic expectation of this year's fundamentals, rather than simply pulling up the valuation. From NetEase's historical valuation range, at a neutral 16x P/E level, although the strength of the pipeline changes and the additional effect of market sentiment, the valuation often fluctuates in the 13x-18x range.

If it is too difficult to track revenue alone, Dolphin Research believes that under NetEase's above-mentioned operating strategy, the impact of the new game pipeline can be gradually weakened, and the long-term value expectation of old game IPs can be increased, that is, regardless of short-term quarterly performance fluctuations, as long as the fundamental business model and company culture are not harmed, then using the annual pipeline as the expectation dimension and measuring short-term interval opportunities with a central 16x P/E is a relatively simple but not low hit rate method.

As for expectations for 2026, the key lies in the performance of two major pipeline games, "Sea of Oblivion" and "Infinity," after their launch. Based on preliminary test performance, the market expects the two games to have an annualized level of 3-5 billion and 8-15 billion in revenue, respectively.

"Sea of Oblivion" is expected to launch in Q2, and if "Infinity" can catch up with the summer public test, Dolphin Research calculates that next year is expected to add 6 billion in revenue (only counting the second half of the year), plus 1 billion from other new games with 75% deferred confirmation over 3-6 months, then an estimated 4.5 billion in revenue will be confirmed, accounting for 4% of this year's total revenue.

In addition, there are some small and medium-sized new games, assuming a total of 1-2 billion in new revenue confirmation, driving 1-2%; existing games remain flat (considering the refurbishment value of old games, the previous decline expectation has been raised). Then the game growth rate next year is expected to reach 8%, and if the two games operate normally, subsequent revenue confirmation throughout the year will continue to accelerate revenue.

Based on this expectation, the current 84.5 billion market value corresponds to a 14x PE expectation for 2026, and there is room to expect a return to the central level of 16x (about 92.5 billion USD). If there is an unexpected progress disclosure for the two new games at the end of the year or early next year, the pre-launch period before the summer at the end of Q2, and potential catalysts (such as changing the main listing location, entering the index, etc.), sentiment is expected to drive the valuation to continue upward, but when it reaches the upper limit of the range of 18x (105 billion USD) or more, it is also necessary to simultaneously reduce risk preference.

Below is a detailed analysis

1. Games below expectations

In the third quarter, game and value-added revenue was 23.3 billion, with core game revenue of 22.8 billion, growing by 12% year-on-year, mainly driven by PC games. The financial report still did not disclose the breakdown of mobile and PC games. Referring to Sensor Tower's revenue data, Dolphin Research estimates (for reference only, to be revised after disclosure in the conference call) that mobile games grew by 3%, continuing to improve from Q2, while PC games grew by 35%, significantly slowing down quarter-on-quarter, mainly due to the fading of low base benefits.

Looking at deferred revenue, Q3 grew by 25% year-on-year and 15% quarter-on-quarter. Calculated, the current period's revenue growth rate was 14%, but in previous years, NetEase had S-level games supporting the third quarter, either mobile or PC games. This year, it mainly relied on the combined efforts of medium-sized new games and old game refurbishments to maintain growth.

(1) Mobile games rely on old game "refurbishment" + new overseas games: The lack of new games led to a continued decline in mobile game revenue, with new mobile games launched in the third quarter including "Spirit Pet Adventure" for the domestic market and "Destiny: Stars" for the overseas market.

According to Sensor Tower data, entering the summer, with the version update of "Egg Party" (three-year anniversary version & summer version), content was enriched, and offline events enhanced player stickiness, leading to a rebound in July-August (domestic revenue +3%). In September, the map update (Qin Chuan) of "Yan Yun Sixteen Sounds" offset the impact of multiple games due to the return to school.

In overseas mobile games, mainly driven by the launch of "Destiny: Stars" in August, other games remained stable year-on-year, and finally, Sensor Tower data showed that iOS revenue grew by 18% year-on-year in the third quarter.

Looking ahead to Q4 and next year, the mobile game pipeline in Q4 is still lacking, and growth pressure is expected to continue until after Q2 next year, when major new games like "Sea of Oblivion" and "Infinity" will gradually be seen.

The company itself attaches great importance to these two games, with market expectations for annualized revenue levels of 3-5 billion/8-15 billion, respectively. These two games have few similar styles to the currently operating games, so the internal erosion impact may be relatively controllable.

(2) High growth in PC games, but expectations may be too high: The increase in PC games in the third quarter mainly came from some Blizzard games, the "Fantasy Westward Journey" play version, and two new games "No Man's Sky" (overseas) and "Top Pursuit."

However, the performance of the two new games was not outstanding, and because they mainly adopted a buyout business model, their overall contribution was limited. The highlight of PC games in the second half of the year is still the overseas version of "Yan Yun Sixteen Sounds" launched in November and the national server of "Diablo 4."

"Diablo 4" has been launched overseas for the past two years, with guaranteed quality, but NetEase mainly acts as an agent, so the gross profit margin is not high. "Yan Yun" has only been online for less than a week, and its initial performance is good, higher than the initial performance of "Naraka: Bladepoint." The product quality itself is good, but it mainly depends on whether overseas users adapt to the Chinese style.

Entering the fourth quarter, new games launched include the national server of "Destiny: Stars," the overseas server of "unVeil The World," the overseas server of "Yan Yun Sixteen Sounds," and the national server of "Diablo 4" expected to launch in mid-December.

However, currently, the performance of the first two games seems to have a high start and a quick decline, and the sustainability of "Yan Yun" remains to be seen. The major new games next year are still "Sea of Oblivion" and "Infinity."

2. Subsidiary business performance is average

Outside of games, Youdao Education and Cloud Music focus on self-sufficiency and profitability recovery. However, revenue in the third quarter was relatively lackluster, more or less below expectations.

In the third quarter, Youdao Education's revenue grew by 3.6%, with growth coming from advertising revenue, while learning machines and online courses continued to decline significantly. In Cloud Music, the negative impact of social entertainment continued to weaken, but overall revenue did not return to positive growth as expected. Other innovative business revenue fell by 19%, significantly below expectations, mainly dragged down by Yanxuan.

Note: Subsidiary businesses are not closely tracked by Dolphin Research, so no further details are provided here. Detailed data can be viewed in the figures.

3. "Over-expected" marketing expenses

In the third quarter, GAAP operating profit (excluding investment income, interest, exchange gains and losses, and other non-core business items) was 8 billion, with year-on-year growth slowing rapidly to 12%, and the profit margin fell to 28% quarter-on-quarter, despite seasonal fluctuations, the decline was too fast.

From the breakdown of costs and various expenses, the main impact on the profit margin was sales expenses, which increased by 17% year-on-year, spending an additional 500 million, and the sales expense ratio rose to 16%.

Excluding the savings from Youdao Education, it means that games + cloud business and other innovative businesses spent nearly 700 million more. The main expenses were on new game promotions and more promotions after refurbishing old games.

For example, "Egg Party" increased IP collaborations, held esports competitions, and multiple offline events such as theme carnivals. This investment was not ineffective, as it significantly activated old players, resulting in a significant increase in "Egg Party" revenue during the summer.

The gross profit margin remained stable quarter-on-quarter, improving by 1 percentage point year-on-year, mainly due to the increased proportion of self-developed games. Ultimately, Non-GAAP net profit was 9.5 billion, as only SBC expenses were adjusted, so although it met expectations, it was mainly due to investment income (8 billion more year-on-year) and other items. Looking solely at the core business operating profit, it was 8 billion, below the market expectation of 9 billion.

4. Repurchase extension, shareholder returns can no longer support additional valuation

At the end of the third quarter, NetEase had net cash of 153.2 billion, equivalent to 21.5 billion USD, an increase of 1.7 billion USD compared to Q1. The third quarter saw normal dividend distribution, but repurchases were almost paused. The 5 billion repurchase quota that started in 2023 was about to expire at the end of the year, and the company decided to extend it for another three years without adding to the quota.

This means that the annualized return rate of the repurchase part, under the current 84.5 billion market value, is less than 1%. Combined with the 2.2% dividend, the overall shareholder return is only 3%, providing little additional support for the valuation.